Whether the setting is Raleigh or Washington, the tax reform debate will inevitably come down to one Big Question: Are you willing to trade current tax preferences for lower marginal tax rates?
Most economists think the answer to this question is obvious. Of course households and businesses should be willing to trade in special tax credits or deductions for a broader, flatter tax system, they say. There is strong empirical evidence for the proposition that such a system lowers compliance costs and increases economic growth. It also tends to promote fairness in the tax code – assuming that tax fairness is (correctly) defined as avoiding political favoritism or large differences in taxes paid as a percentage of income or assets.
To some taxpayers, however, a revenue-neutral tax reform that offers to trade lower rates for fewer preferences may lack appeal. If you work in a sector that benefits from special tax breaks, such as high-end real estate or wind energy, those breaks may well be more valuable to you than lower rates or compliance costs. Also, if you harbor a suspicion that the terms of today’s tax reform won’t stick – that politicians will use lower rates as a pretext for abolishing tax breaks, then raise the tax rates in the future – you may say no even to a deal that appears to benefit you in the short run.
These are among the reasons why tax reform is a bit like a TV meteorologist. That is, it looks great from afar, or on a low-resolution screen. Close up, in high definition, imperfections become evident.
Still, we watch. And as for tax reform, we can’t afford not to move forward. Our effective tax rates on corporate income and capital formation are among the highest in the world. They reduce the competitiveness of our economy and reward current consumption over long-term, productivity-enhancing investment.
The key to unlocking the tax-reform door is to recognize that it isn’t really all about marginal tax rates. The best-available tax system isn’t the one that tallies up everyone’s gross income and applies a tax rate to it. Yet some descriptions of “tax expenditures” assume exactly that. They list both the $100 billion-a-year mortgage-interest deduction (which truly is a special-interest tax break that disproportionately benefits upper-income taxpayers and those who build their homes) and the $100 billion-a-year deduction for deposits into IRAs and 401ks (which is a policy for making taxes neutral with respect to current vs. future consumption). Such a description is utter nonsense, incoherent and unhelpful to policymakers.
You have to start with valid definitions. Income isn’t just transferring cash from one pocket to the other. It is best understood as a current monetary return on some prior investment – a return on financial or physical capital, in the case of dividends and capital gains, or a return on human capital, in the case of wages. If government taxes the resources taxpayers spend to accumulate and deploy that capital in the first place, such as deposits into investment accounts or the rearing and education of future workers, then it shouldn’t also tax the return on those investments. Otherwise, its tax code discourages long-term investment in favor of short-term consumption. The results are complexity, unfairness, and weaker economic growth.
So a properly structured tax system would retain tools such as generous personal exemptions (especially for children) and savings deductions. These tools shield capital formation from tax at the front end, since the returns on that capital are taxed later on. Reformers shouldn’t try to persuade or compel taxpayers to give up these safe harbors in the tax code.
On the other hand, narrow tax preferences for housing debt, municipal bonds, eco-friendly projects, or non-wage benefits favor some forms of capital formation and maintenance over others. Any sensible tax reform ought to reduce or eliminate them, in exchange for lower rates.
In reality, most households and businesses demonstrate by their own behavior that they favor simplicity over retaining such preferences. Most households take standard rather than itemized deductions, for example, and most small to medium-sized businesses either aren’t eligible for special tax breaks or decline them as not worth the compliance burden. They form a large consistency for fundamental tax reform. They deserve to get what they want.
Hood is president of the John Locke Foundation and a contributor to First in Freedom: Transforming Ideas into Consequences for North Carolina.